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August 2015 is now being referred to as ‘Black Monday’, the Shanghai Composite dropped 8.5%, making it the worst day for the stock exchange since February 2007.

Doubts initially began to spread as weaker than expected Chinese data was released in June, making many begin to fear that China was not the unstoppable economic force that they thought it was. As panic spread and the Chinese markets began to decline in value, the Chinese government attempted to prop up the market by dropping interest rates, pumping liquidity into the markets, using reserves to purchase the Yuan to prevent it from sliding further against the dollar and by purchasing millions of dollars worth of blue chip stocks. Yet despite their attempts, the Chinese government was unable to impact the markets enough and last Monday the stock market lost more than 40% since peaking in June, a bigger drop than the dotcom bust. Some 2,153 stocks trading in Shanghai and Shenzhen fell by the 10% daily limit allowed by regulators, according to Wind Information Co, meaning that losses were so severe that 2/3 of mainland shares became untradeable until the following day.

The Chinese crash disturbed the rest of the global economy as well as its own, causing asset classes around the world to be dragged down along with the Asian powerhouse. Examples include the Dow Jones in the US, which fell 1000 points lower on Monday’s opening bell. Commodities, Emerging and European markets all additionally suffered big losses. Since the Yuan devalued earlier this month, $5 trillion has been wiped off the global equity markets

“What we’re seeing is not a reasonable correction…We’re definitely in the world of psychological downturn.” tweet
David Stubbs, Global market strategist, JP Morgan Asset Management

Behavioral economics

The rise and subsequent fall of the Chinese stock market provides a perfect case study for the behavioural economist enthusiasts among us to study the irrationality of investors and the mental heuristics and shortcuts that occur in the markets on a daily basis. Emotions can often get the best of investors and can influence the markets for reasons other than rational decision-making. Behavioural economics played a key role in the Chinese crash seen this week and it is beneficial to investigate how and why.

The Chinese Bubble

Robert Shiller, in his popular tome ‘Irrational Exuberance’, defines a speculative bubble as ‘a situation in which temporarily high prices are sustained largely by investors’ enthusiasm rather than by consistent estimation of real value.’ Technical analysis suggested that the rise in the Chinese stock market was not supported by the fundamentals. For example the market cap to GDP ratio, which is often used as an indicator of risk in equity markets, grew by 124% in the past year, climbing to 2006-2007 levels.

Despite it being obvious to experts that the Chinese stock market was a bubble set to burst, evidently a vast majority of investors did not comprehend this fact and continued to purchase assets, most likely through greed and an overly positive view on the Chinese economy. Thousands of unprofessional Chinese citizens borrowed money to invest in the stock market, such as the notorious farmers in Nanlui village, who set up makeshift trading rooms and ploughed their savings into the market as they felt more gains were to be made in the stock market rather than cultivating their crops. Many blame the Chinese financial regulators for not intervening earlier, despite being fully aware that the market was overheating:

“Regulators could have been more aggressive in managing margin trading and collateral rules,” said Andrew Wood, a Singapore-based China analyst for BMI Research, a unit of Fitch Ratings. “It was already clear that the market was quite frothy by the beginning of this year.” tweet
Availability Bias

Availability bias is the behavioural concept that describes how our environment can shape our perceptions. While regulators should have perhaps have done more to prevent speculative stock plays, one of the main driving forces behind the buying frenzy earlier this year was the bullish sentiment signals sent by Chinese state news agencies such as the Xinhua News Agency:

“A series of pro-market articles from Xinhua over the course of the past year exhorted readers not to miss out on what it deemed to be close to a sure thing” tweet
Andrew Wood

This constant exposure to excessively optimistic news headlines led to (consciously or unconsciously) a biased view of the markets by many investors rather than an objective stance that focused on the stock fundamentals.

Herding and Overconfidence

The Chinese rise and crash is a perfect example of the behavioural finance phenomenon ‘herd behaviour’ whereby investors imitate others when making investment decisions. New investors are often seized by feelings of greed, envy or pride when they obsess over the market and compare their portfolios to others. Social norms and trends can lead to the inexperienced investor to copy others, causing them to rush to exit their positions due to the market sentient at the time.

Originally, the Chinese market soared due to overconfidence that the Chinese market gains were unstoppable, with many investors having no real idea about the true value of the assets they were buying. As the CSRC Chairman, Xiao Gang, put it, investors stampeded into the market “blindly, like sheep.”

Similarly, when the bubble burst, people panicked and flocked for the exits due to a collective loss of confidence in the Chinese economy.

Speculation

Despite knowing that the Chinese market was set to pop, some continued to pump up the bubble via speculating on stock movements. Many traders rely on momentum trading and investor psychology to make their margins and the Chinese stock bubble was a perfect opportunity for them to make substantial profits. Although they recognised that the assets they purchased were overvalued, many momentum traders believed that they would be able to sell at an even higher price in coming weeks, days, hours, minutes or even seconds due to illogical trades being made by amateurish investors. Subsequently, skilled traders will have shorted the market as fear and panic kicked in and the markets began to slide.

Man vs. Machine

Some argue that humans were not to blame for the crash, and rather it was the workings of emotionless supercomputers that caused the slump in the stock markets. Numerous trading firms utilise complex algorithms to make deal decisions on behalf of investors. These systems can cater for specific risk appetites and portfolio goals and are often set to exit positions once stocks fall below a certain level, known as stop-losses. These models will have unquestionably spurred the domino effect of asset selling seen around the world this week, yet to what extent it is unknown.

Focus on the Long Term

Unless you have a part time job as a day trader, it is critical that you prioritise your long-term investment goals, be patient and do not to sell your portfolio for the wrong reasons. Focusing on the short term can lead to sub optimal decision making and unnecessary transaction costs as you leave and re-enter markets. It is essential to remember that the stock market fluctuates and will have its upswings and downswings for many years to come.

The Silver Lining

For the value investors among us – who aim to purchase stocks at less than their intrinsic value – now may be the perfect time to enter the global markets. There are a number of inviting stocks trading at a generous discounts after this week’s fire sales, particularly in emerging and US markets, but perhaps this is best left for another article.

Let me leave you the words of Warren Buffet, arguably the world’s most successful value investor.

“Be fearful when others are greedy and greedy when others are fearful” tweet
Of course, stay clear of companies in highly leveraged or poorly competitive positions, but it makes no sense to worry about the prosperity of fundamentally sound companies that, although will have their hiccups throughout the years, such as instances of poor short term performance or via systematic shocks, will continue to set new profit records for years to come. Do you have the composure and self-assurance to enter the market after this week’s chaos as others rush for the exit?